Posted: Wednesday, 21 November 2007

The unprecedented surge in the Canadian dollar from 85 cents US in early 2007 to as high as $1.10 in early November is deeply disturbing in terms of its implications for the health of the economy and the job market. Very rapid exchange rate appreciation is bad news for most enterprises exporting abroad, or competing with US and Asian exporters in the Canadian market.

The especially vulnerable manufacturing sector has already lost another 91,600 jobs over the past year (November 2006 - November 2007) on top of the 223,000 jobs already lost between November 2002 and November 2006. The pace of job loss is clearly accelerating, and manufacturers are widely expected to cut more jobs and close more operations in 2008. Between June and September of this year alone, manufacturing output fell by almost 2%.

An exchange rate which remains at or above parity will destroy cost competitiveness for other large and important portions of the Canadian economy such as tourism, cultural industries and those selling services into the US and Asian markets, not to mention those parts of the economy providing services to the manufacturing sector itself. Parity raises the fundamental question of whether the resource boom will destroy a significant part of our current economic base, greatly exaggerating regional economic differences.

Exchange rates can and do ‘over-shoot' the level justified by fundamental factors, with permanent structural damage being inflicted if a serious over-valuation persists.

One estimation of a ‘correct' exchange rate is that needed to equalize prices in two countries. Current best estimates of an exchange rate that equalizes US and Canadian prices (the Purchasing Power Parity or PPP exchange rate) are in the low 80 cent US range.

Another estimation is the exchange rate needed to equalize cost competitiveness in traded sectors, usually proxied by unit labour costs in manufacturing as regularly reported by the US Bureau of Labor Statistics (BLS). Canadian business sector-wide productivity is estimated to be about 80% of the US level. Manufacturing productivity (real GDP per hour worked at PPP) has been estimated to be even lower at about 75% of the US level. Canadian and US manufacturing wages (measured in respective national currencies) were about equal in Canada and the US in 2005. It follows that a Canadian dollar above the low 80 cent range sharply erodes competitive unit labour costs compared to the US. Recent BLS data indeed show a sharp increase in Canadian unit labour costs in manufacturing compared to the US in 2005 and 2006, driven by the exchange rate appreciation. (There is more to cost competitiveness than unit labour costs, but some long-standing Canadian advantages such as lower power costs have eroded in recent years).

The key point is that, well before we hit parity, a high proportion of Canadian operations found themselves with much higher cost structures than comparable US operations. A continued seriously over-valued exchange rate will push many out of business, and the challenge is greatly compounded by increased low wage competition from Asian countries with currencies closely tied to the US dollar. True, companies can pursue strategies which minimize the impact of relatively high unit labour costs, but this requires high and sustained investments in innovation.

The Government of Canada in the November Economic Statement, and the Bank of Canada in its October 2007 Monetary Policy Report, concede that there are threats to economic growth if the dollar moves above parity. Concerns have also been expressed by the Premiers of Ontario and Quebec and even by the Prime Minister. However, at this time, the Bank of Canada still seems prepared to accept an exchange rate of close to parity.

It is argued here that the Bank of Canada can and should continue to lower interest rates significantly so as to put the brakes on the rising dollar.

What is Causing the Recent Surge of the Dollar?

The dominant, official view is that the surge of our dollar to at or near parity is justified by Canada's improved terms of trade with the rest of the world (i.e. soaring prices for oil, many minerals and some agricultural commodities), and by the need of the US to deal with its huge trade and current account deficits. Much of the rise of the Canadian dollar is held to be the flip-side of a falling US dollar, which has affected most currencies which are not fixed or managed relative to the US dollar.

However, most observers seem to agree that recent trends in commodity prices do not fully explain the most recent rise of the Canadian dollar to and above parity. True, the price of oil has surged close to $100 US per barrel, and the Canadian dollar is widely perceived to be a ‘petro-currency'. But oil exports (crude oil plus refined petroleum products) make up only 12% of our total exports, and this is unlikely to rapidly increase given the depletion of conventional oil supplies and the long lead times before exports from the development of the tar sands begin to grow rapidly. Current oil exports amount to far less than the struggling auto sector which still contributes about 20% of exports. Energy exports in total account for close to 20% of exports, but this includes natural gas exports for which prices have recently been at depressed levels. Also, while our terms of trade do improve with higher oil prices, there is an offset arising from the fact that we also import large quantities of oil.

It has been widely observed that increases in oil prices ‘explain’ the rise of the Canadian dollar in econometric models. However, this does not mean that the dollar is at the ‘right’ level so far as the needs of the real economy are concerned. The Canadian dollar may be mis-perceived as a ‘petro currency’, and the apparent link between oil prices and the dollar may be a financial as opposed to real economy linkage, driven by foreign financial and direct investment in resource sector equities more than by an expansion of the resource sector itself.

It is far from clear that rising commodity prices will soon translate into a rising trade and current account surplus which would justify rapid exchange rate appreciation. In point of fact, our positive overall merchandise trade balance with the rest of the world is slipping rather than rising as many manufactured exports are being hit hard by the high Canadian dollar, and as the prices received here in Canada by energy and other resource producers are eroded by the increase in the exchange rate. The just-reported September 2007 merchandise trade surplus was the lowest since December 1998, and the current account surplus fell sharply in the third quarter of 2007.

Measured in US dollar terms, commodity prices, including energy prices in the aggregate, have risen significantly in 2007, but they have not risen when translated into Canadian dollar terms. (See the Bank of Canada commodity price index). True, crude oil prices have recently risen even in Canadian dollar terms, driven in part by speculation and in part by fears of ‘peak oil', but the increase in the value of crude oil exports in the near to medium term will not outweigh the continued worsening of our deficit in the trade of manufactured goods.

Canada's deficit in the trade of manufactured goods has exploded in recent years, hitting $28 Billion in 2006. It's true that we are now exporting a lot of oil and gas and minerals, but resource exports can finance only about one-fifth of our imports. Some see service exports as the way to pay our way in the world in the future, but services make up only 13% of our exports; we run a huge ($14 Billion) deficit in the trade of services; and service exports have not been increasing rapidly. Put it all together, and an ever-increasing manufacturing trade deficit driven by a high and rising dollar is unsustainable and will likely soon lead to a deficit in the balance of payments on current account.

The Canadian dollar is clearly not the only currency to rise against the US dollar in recent months, but the scale of our exchange rate appreciation has been exceptional. The Euro has also appreciated against the US dollar, but the Canadian dollar has risen relative to the Euro. The cost of a Euro in Canadian dollars has fallen from $1.54 in early 2007, to below $1.50 by mid-year, to just $1.34 in early November. Even though we are a relatively small economy even in terms of the total volume of US trade, Canada has borne about one-third of the impact of the US dollar depreciation since 2005.

The fall in the US dollar against many other currencies has begun to slowly improve US exports and lower the huge US trade and current account deficit. However, the US share of the Canadian market for imports is actually falling, while much of the falling Canadian share of the US market for manufactured goods is being filled by Asian rather than US domestic producers. China, Japan and other Asian exporters collectively account for a far larger share of the US trade deficit than does Canada, but they have avoided the burden of adjustment by fixing or managing their own currencies relative to the US dollar. In short, we are bearing an unfair share of the burden of US dollar depreciation, and playing a minor role in resolving US trade imbalances. These can, in fact, only be resolved by a major appreciation of the Chinese and Japanese currencies against the US dollar, which would benefit Canada as well as the US.

There is clearly a close relationship between recent changes in Canada-US interest rates and the Canada-US dollar exchange rate. The Canadian dollar was trading at 85 cents US in early 2007, rising to 91 cents US in May. The widely anticipated increase in the target for the overnight rate from 4.25% to 4.5% by the Bank of Canada on July 10 helped push the Canadian dollar to the mid-90 cent US range in July.

The surge of the Canadian dollar to parity with the US dollar and well beyond was then fueled by the half-point cut in the target for the US federal funds rate on September 18, which helped push the Canadian dollar to parity at the end of September. This was followed by another quarter-point cut at the end of October, and a further surge in the Canadian dollar well above parity.

Policy actions by central banks eliminated the 1% difference between Canadian and US policy rates which existed in July, encouraging rather than discouraging investors from moving into a rising currency. This was almost certainly linked to the recent surge of the Canadian dollar. While it was mainly US rate cuts from initially higher levels which eliminated the initial interest rate differential, the Bank of Canada could have matched those US rate cuts, but chose not to.

On December 4, the Bank of Canada did reduce the target for the overnight rate by one-quarter of one percentage point, but this had only a small impact on the exchange rate since it merely matched the expected quarter point expected soon in the US. Moreover, the Bank of Canada has signaled that it is comfortable with a dollar close to parity, and appears unwilling to further reduce interest rates.

On top of the elimination of the interest rate differential between Canada and the US, it would seem that speculation has played a notable part in the most recent run-up of the Canadian dollar. Often, movements prompted by ‘real' economic forces such as interest rate differentials and changes in trade flows are compounded by speculators such as hedge-funds and bank trading desks seeking short-term profits on gyrating currency movements.

The Exaggerated Fear of Inflation

The Bank of Canada argues that its central and most useful goal is to meet the 2% inflation target and that it has no target for the exchange rate which it sees as mainly driven by improved terms of trade and the fall in the US dollar. The Bank sees a higher Canadian dollar as part of the ‘transmission mechanism' through which higher interest rates will slow economic and job growth to achieve its inflation goal. (In a very nuanced way, however, the Bank has said that the rise in the exchange rate above and beyond parity would be damaging if fueled by speculation).

The Bank's central argument has been that the Canadian economy is operating ‘above capacity', as shown by inflation recently running slightly higher than the desired 2% mid-point of the target range (though not, it should be said, higher than the 3% ceiling of the target range). That is why the Bank raised interest rates earlier this year, and why it has not lowered them since to match US rate cuts.

Currently, there is a great deal of economic commentary to the effect that the US economy is flirting with recession, while the Canadian economy is booming and increasingly less dependent upon the US because of a booming resource sector fueled by Asian growth. However, one has to note that growth in Canada is currently running lower than in the US. (US real GDP grew by 3.8% and 3.9% in the second and third quarters, compared to 2.5% in Canada in the second quarter). The TD Bank's most recent forecast is for 2.6% growth for Canada this year compared to 2.0% in the US, but for growth of just 2.3% in Canada in 2008, less than forecast growth of 2.4% in the US. The Government of Canada Economic and Fiscal Update reports a private-sector consensus forecast of 2.4% for Canada in 2008, only slightly above 2.1% growth in the US. Almost certainly, however, these Canadian growth forecasts will be revised down sharply if the Canadian dollar remains above parity.

There is certainly a significant risk of US recession given the housing crisis and the sub-prime and resulting credit squeeze, which is why the US Federal Reserve has acted pre-emptively with some success by cutting interest rates. There is equally a significant risk of a recession in Canada as a result of a seriously over-valued exchange rate combined with a US slowdown.

With respect to the supposed risk of accelerating Canadian inflation, the core rate in September was at 2.0%, precisely the Bank target and the lowest increase in the core rate in several months. The national rate is boosted by high Alberta inflation (4.6%). In all probability, inflation will fall as the rise in the Canadian dollar from the mid 80-cent range earlier this year does gradually feed through into consumer prices.

The Bank of Canada appears to be concerned by the implications for inflation of an unemployment rate of less than 6%, and hourly-wage growth of just above 4% when measured by its favourite indicator (wages of permanent workers). However, the Survey of Employment, Payroll and Hours shows that average hourly earnings of hourly-paid workers rose by just 2.2% in the year to August, and average weekly earnings of all workers were up by 3.1%. Wage settlements for unionized workers are running at just above 3% in both the public and private sectors. Real wages are hardly exploding, especially for lower-paid workers. In the year August 2006 to August 2007, hourly wages of hourly-paid workers actually fell in retail trade (from $15.25 to $14.88 per hour) and hourly wages grew by just 2.6% in accommodation and food services, to the princely level of $10.76 per hour. One would expect a truly tight job market to be raising pay for the lower-paid, but this is just not happening.

Despite some reports to the contrary, job growth is tilted towards low-paid and relatively precarious jobs. Data from the Labour Force Survey for November 2007 show that one-third of the net new jobs created over the past 12 months came in the form of self-employment and temporary employment combined. Of the 285,000 payroll jobs created over the past year (August 2006 to August 2007, seasonally adjusted, SEPH data), almost half (46% or 130,000) were in the two lowest-paid broad industrial sectors, retail trade (85,000 net new jobs), and accommodation and food services (45,000 net new jobs). While net job growth in these sectors made up almost half of all net job growth, they accounted for just one in five of all payroll jobs one year ago. At the margin, then, job growth is heavily tilted to precarious forms of employment and low-wage service industries.

One implication is that workers displaced by the high dollar from manufacturing and other above average productivity jobs are unlikely to find comparable new jobs. Another implication is that the labour market is not nearly as tight as a high-employment rate and low-unemployment rate would suggest. Confronted with a truly tight job market, employers would be offering new hires steady employment, and employers in low-wage sectors would be having to raise wages to retain workers. (We do see this in Alberta but not in Canada as a whole).